A shortage of dollars and high demand for the currency globally are stretching certain dollar-based rates to levels more associated with periods of extreme market stress, raising a red flag for the wider financial system. Record-low investment returns are forcing investors in the euro zone and Japan to buy US bonds, which is having the negative and potentially costly effect of depressing US yields and the profitability of the country's banks.
On the surface, banks are in far healthier shape now than at any time since the 2008 financial crash and recession. But strains in the cross currency basis markets, particularly the Japanese yen, is giving central bankers food for thought. The Bank for International Settlements has twice warned in the last month about the risks to global financial stability posed by "anomalies" in currency markets resulting from the dollar's rise over the last two years.
These anomalies have come under particular scrutiny in recent weeks as the dollar's rally has eased off. But instead of pulling back in tandem, the premium for dollar funds in the FX basis market has continued to rise. FX basis, effectively the cost of swapping one currency into the other without the exchange rate risk, are a measure of the scarcity of one currency relative to another. In benign markets, they will show virtually no premium for one over others.
Multinational corporations who need dollars for financing purposes, or more sophisticated investors wanting to take advantage of the interest rate differentials, are typically those involved in the FX basis markets. Demand for dollars during the 2007-08 financial crisis pushed that premium to record levels far above the norm, reflecting the unprecedented stress in the system.
Trillions of dollars of central bank liquidity and years of zero - and even negative - interest rates have brought that risk premium down, but it remains significant. And negative yields in the euro zone and Japan are in large part to blame. Stuart Sparks, a rates strategist at Deutsche Bank in New York, says the demand for higher yielding US assets from the euro zone and Japan is causing "market dislocations" and could depress the profitability of US banks over time.
"This is lowering asset returns available to US banks and US net interest margins. And at a time of higher capital requirements, it's a concern," Sparks said. The value of US bank stocks has fallen 4 percent so far this year, underperforming Wall Street's broader indices, which are up 4 percent.
The three-month dollar/yen currency basis is trading at -75 basis points, signifying a 75 bps premium for dollar funding over comparable yen borrowings. The basis was around -60 bps or more for most of this year, and neared -100 bps in late 2011. The three-month euro/dollar currency basis is trading around -38 basis points, the most deeply negative this year. But it was double that late last year, reached -160 bps at the height of the euro zone crisis in late 2011, and -300 bps in September 2008 when Lehman Brothers collapsed.
While far short of these extreme levels, the premium for dollars now, eight years after the financial crisis, is notable. Pre-crisis, euro and dollar funding costs were virtually equal. A reflection of the rising demand for dollar funds can be seen in the surge in dollar-denominated debt issuance from Japanese firms this year. A total $29.8 billion has been issued, up 70 percent from the same period last year and the highest in over a decade, according to Thomson Reuters data.
According to Fitch Ratings, over $10 trillion of government debt around the world offer negative yields, almost entirely in the euro zone and Japan. All euro zone yields out to nine years and Japanese yields out to 10 years are below zero. This has contributed to a dramatic flattening of yield curves, not only in the euro zone and Japan but also in the United States. The difference between 10- and two-year US yields is around 90 basis points, meaning the yield curve is its flattest since 2007. Banks prefer steep yield curves because it means they can profit from borrowing short-term funds cheaply and lending long term at higher rates.
The Japanese and euro zone curves are even flatter. Japanese and euro zone financial stocks this year are down 30 percent and 20 percent, respectively, pushing investors into US markets. But rising dollar funding costs could force banks to get dollars from less conventional sources, such as the dollar swap lines between the Federal Reserve and other central banks opened up in the aftermath of the crisis.
"Some of the basis levels we are now seeing have gone beyond the point where dollar lending facilities provided by central banks have been taken by investors in the past," said Fabio Bassi, head of European Rates Strategy at J.P. Morgan in London. "With some of these facilities already in place, I would give it less than a 50 percent probability to a more active policy response from central banks."
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